PRE-SETTLEMENT RISK
Veronica Marchetti
Muhammad Naeem
Agenda
 The Nature of Pre-Settlement Risk:
Definition and Implications
 An example of Pre-Settlement Risk
 Methods of estimation of Pre-Settlement risk
 Tools mitigating Pre-Settlement Risk
 Regulation Before and After the Crisis
THE NATURE OF
PRE-SETTLEMENT RISK
During the last twenty years the sustained growth
experienced by derivatives traded in Over The Counter
markets has promped a need for an adequate
measurement of the credit risk associated with such
contracts.
The detention of a financial instrument involving one or
more cash flows to be paid at a later date in the future
gives rise to a Pre-Settlement Risk,
the risk that the counterparty may default
before the contract’s final maturity.
THE NATURE OF
PRE-SETTLEMENT RISK (2)
COUNTERPARTY RISK
PRE-SETTLEMENT RISK
specialized category of credit risk that arises if
either the
counterparty defaults
before the payment is
due
or the financial intermediary
responsible for the
settlement declares
bankruptcy before the
transaction is settled.
Calculating potential credit loss require s the modeling of
Three Processes
•The probability that default occur
•The counterparty credit exposure at time of default
•The amount that can be recoved after the default.
EXPECTED LOSS= PD X EAD X LGD
Managing Credit Exposure
• Exposure at default on OTC derivative transactions is determined by
modeling the potential evolution of the replacement value of the portfolio
of trades with each counterparty over the lifetime of all transactions.
 For all traded products, the exposure at default is derived from a Monte
Carlo simulation of potential market moves in all relevant risk factors,
such as interest rates and exchange rates.
The randomly
simulated sets of risk factors are then used as inputs to product specific
valuation models to generate valuation paths.
 In case of a default, it may be possible to recover part of the amount owed.
The proportion of the amount which cannot be recovered is called loss
given default.
 Probability of Default of the counterparty is computed through different
techniques ; Linear Discriminant Analysis , Regression Models and
Inductive Heurisitic Methods allow to discriminate the potential
counterparties in relation to their creditworthiness.
THE NATURE OF
PRE-SETTLEMENT RISK (3)
Replacement cost is a basic metric of credit exposure due to presettlement risk. It is the cost to the institution of having to completely
replace all contracts with that counterparty.
TYPE OF EXPOSURES
ACTUAL EXPOSURE
POTENTIAL EXPOSURE
is the replacement cost of a portfolio of The potential exposure of the contract is
contracts with a counterparty based upon the maximum additional amount that will
those contracts' current market values. be lost if default occurs at some time t* ,
t< t*< T.
DERIVATIVE
POSITION
LIABILITY
NO CREDIT EXPOSURE
In a third case the position can be an
asset or a liability depending on the
market fluctuation.
ASSET
CREDIT EXPOSURE
So there is a possibility of
loss when the position is an
asset and no loss when the
position is a liability
EXAMPLE OF
PRE-SETTLEMENT RISK
•
Operator A makes a forward purchase of foreign currency from operator B,
let say the U.S. dollar to six months at the price of 1.1 euros per dollar.
EURO VS DOLLAR
€
6 month
A
•
•
$
$
B
€ =1.1
$
From the point of view of €
the operator A, the PRE-SETTLEMENT RISK
refers to the possibility that, in the six months preceding the expiration date,
the operator B becomes insolvent and simultaneously the position has a
positive market value, i.e. the dollar is quoted at a higher price.
Thus, for example, if three months later the dollar at three months is quoted
at 1.2 euros, the operator A will suffer, in case of insolvency of B, a loss of 0.1
euros per dollar originally purchased.
EURO VS DOLLAR
3 month
C
A
$
€
€
$
B
DEFAULTE
€
=1.2
$
The pre-settlement risk produces a loss if, when
the counterparty defaults, the market value of
the contract is greater than zero.
In this case the bank will have to face a cost when
substituing the defaulted contract with a
similar one at new conditions;
this is why the pre-settlement risk is also called
substitution risk.
The worst case loss assumes an adverse
movement in the price/ rate, the client
default and the subsequent cost of re-covering
the transaction again from the open market.
ESTIMATING
PRE-SETTLEMENT RISK
The main measures of pre-settlement risk are
LOAN EQUIVALENT EXPOSURE and PEAK EXPOSURE .
Pre Settlement Exposure (PSE) = MV of Derivative + Maximun Deviation of MV
Estimating pre-settlement risk is a difficult task, in fact, the future
substitution of a contract doesn’t only depend on its current value but also
on the further value increase that may occur between now and the the time
of counterparty’s default.
FUTURE POTENTIAL
EXPOSURE
CURRENT EXPOSURE
LEE
Taken together, these exposures represent the LOAN EQUIVALENT
EXPOSURE of an OTC derivative , that is, the value that can be assigned
at the exposure in the event of a default.
ESTIMATING
PRE-SETTLEMENT RISK (2)
The main ways to estimate the LEE associated with derivative contracts
on interest rates and currencies were defined by the Basel Committee on
Banking Supervision for regulatory purposes.
LEE is computed using a parametric
approach where percentiles can be
expressed as multiples of the market
factors’ historical volatility.
LEE is computed using the ORIGINAL
EXPOSURE METHOD, where CE and FPE
are not assessed separately but LEE is
computed directly as fixed percentage of
the notional value of the contract.
Alternative Approaches
 Alternative approaches to compute LEE based on option pricing
models and historical / Montecarlo simulations.
 A VaR based approach is used in calculating the PSR limits when
we want to set a limit to losses deriving from this kind of risk
based on the worst case scenario.
ESTIMATING
PRE-SETTLEMENT RISK (3)
PEAK EXPOSURE APPROACH
Future Potential Exposue (FPE) changes with time and one has to choose the
most appropriate time horizon or to find a way of summarizing different
measures of EXPOSURE RISK into just one figure.
This approach uses the maximum FPE relative to moment τ , i.e. the time
in years when future value is estimated.
Simple solution
The Counterparty Risk is never underestimated
BUT
Overestimation of the effects of default
AVERAGE EXPECTED
An alternative method is basedEXPOSURE
on a weighted average of expected
exposure for different τs using a system of weights proportional to the
discount factors associated with different maturities.
VAR-based Approach
 Using volatility this model estimates the worst case possible price
move (value at risk or VAR) and then estimates the value of the
solution through pricing models.
 It then evaluates the impact of a default if the counterparty is unable
to fulfill his commitment.
VOL
VAR
PSR
DEFAULT
IMPACT
WORST
CASE
MOVE
PRICIN
G
MODEL
 Stress testing are used in particular after the crisis scenario of the last
years and
different stress test approaches are followed:
Hypothetical & Historical stress testing, Expected Shortfall.
TOOLS TO REDUCE
PRE-SETTLEMENT RISK
There are several ways to reduce pre-settlement risk; the main
ones are the following:
Safety
Margins
Recouponing
and
Guarantees
Credit
Triggers and
Early
Redemption
Options
Bilateral or
Multilateral
Netting
Agreement
Bi-Multilateral netting agreements
 Netting Agreements allow to net all positions towards a defaulting
counterparty, so that those with negative market value may offset the ones
having a positive current exposure. If counterparties have multiple offsetting
obligations to one another—for example, multiple Interest Rate Swap or FX
Forward Contracts—they can agree to net those obligations.
2
Party
B
Party
A
1
3
Party
C
EXAMPLE OF THREE
BILATERAL NETTING.
If Party C defaulted, the
replacement cost for Party A
would be 3. For Party B, there
would be no replacement cost
because Party C owes it no
net obligation.
Recouponing and Guarantees
 This tool is based on the fact that the periodic settlement of the market value
of the OTC contract is replaced by a new one in line with current market
conditions and in order to set the current exposure to zero.
Credit Triggers
and
Early Redemption Options
 These are tools that allow for the early termination of the contract
CREDIT TRIGGERS
if a given event occurs ,
usually a rating
downgrade for one of
the two parties.
REDEMPTION
OPTIONS
at the mere discretion of
one counterparty
Safety Margins
 Margins applied to OTC derivatives are similar to those required by central
clearinghouses on futures: when two counterparties enter a futures contract, they
have to provide an initial margin that will then be increased or decreased based on
the daily changes in the market value of the contract.
HOW PRE–SETTLEMENT RISK IS
REGULATED?
“With a two-day dollar-yen deal, there’s not a lot of presettlement risk. But with a five-year dollar-Polish zloty swap?
There’s risk there that someone might want to manage.”
Derek Samman, head of FX at the CME
 Most market practitioners assess pre-settlement risk to be very low for spot
transactions settled in two days.
For
longer-dated trades, the risk is established by taking the appropriate spot rate and
then assessing the interest differential between the two currencies to establish the
forward . Such counterparty credit risk is currently managed in the FX market via
either netting, covered within the close out netting clause in trading agreements
or through the exchange of collateral between counterparties.
 The pre-settlement risk is minimized when counterparties are required to
undergo a credit check before being approved for trading.
REGULATION BEFORE THE CRISIS
“Recommendations for Securities Settlement Systems”
report of the CPSS-IOSCO Joint Task Force
on Securities Settlement Systems, Bank for International Settlements,
November 2001.
1. Trade confirmation
Confirmation of trades between direct market participants should occur as soon
as possible after trade execution, but no later than trade date (T+0). Where
confirmation of trades by indirect market participants (such as institutional
investors) is required, it should occur as soon as possible after trade execution,
preferably on T+0, but no later than T+1.
2. Settlement cycles
Rolling settlement should be adopted in all securities markets. Final settlement
should occur no later than T+3. The benefits and costs of a settlement cycle
shorter than T+3 should be evaluated.
“Recommendations for Securities
Settlement Systems”
(2)
3. Central Counterparties (CCPs)
The benefits and costs of a CCP should be evaluated. Where such a mechanism
is introduced, the CCP should rigorously control the risks it assumes.
4. Securities lending
Securities lending and borrowing (or repurchase agreements and other
economically equivalent transactions) should be encouraged as a method for
expediting the settlement of securities transactions. Barriers that inhibit the
practice of lending securities for this purpose should be removed.
REGULATION AFTER THE CRISIS
“Banks are of course looking again at all the risks they run and
they’re definitely looking at pre-settlement risk and the potential
need for longer-dated FX to be cleared, but I don’t think they see it
as the biggest issue for FX.”
Rob Close, chief executive of CLS.
.
 Post-crisis reforms derive from the process of strenghten by the Congress
and regulators of the establishment of central securities depositories and
CCPs to immobilize paper certificates, encourage multilateral netting of
trades, reduce pre-settlement risk through the guarantee of trades, and
conduct securities settlements through "book entries" to electronic records.
 Today, the majority of FX derivative trades are executed and settled bilaterally,
with market participants typically facing a bank throughout this process. A
small minority of trades are executed on futures exchanges and centrally
cleared.
 Under the proposed regulation, financial counterparties will be forced to
centrally clear FX option products.
REGULATION AFTER THE CRISIS (2)
CREDIT DECISION TREE
CLEARIN
G
CCPs
BILATERAL
CVA
CSA
 Central clearing replaces the bilateral credit risk of the OTC market with
systemically important CCPs as the legal counterparty to each trade. This
clearing process will require the payment of initial and variation margin. In
clearing bilaterally, there will be a choice between a collateralized approach
using a Credit Support Annex (CSA), or an uncollateralized approach which is
subject to a Credit Valuation Adjustment (CVA).
 Basel III regulations markedly increased the capital requirements and hence
the cost of uncollateralized exposures in line with the tendency to strengthen
clearing trade solution.